exam 3
If the price is greater than the principal, what does this indicate? high or low demand? what is this type of bond called?
your bond is attractive high demand premium bond
If the price is less than the principal, what does this indicate? high or low demand? what is this type of bond called?
your bond is unattractive low demand discount bond.
Arrange the following based on a high to low coupon rate: debenture (D), subordinated debenture (S), income bond (I), mortgage bond (M).
(1)i (2) s (3) d (4) M
As an investor, how is the value of a stock is calculated?
(formula) -REQUIRED RETURN (based on the risk of the stock), -DIVIDEND I expect to receive from the company - and the constant GROWTH RATE that I expect for the company
2 scenarios for bond cash flows
**Scenario 1: You know the i (required return) of an investor and you will solve for the bond's PV(value). **Scenario 2: You know the bond's PV(market price) and you will solve for the i (YTM) an investor will earn.
Zero Coupon Bonds
- Bonds that are initially sold at a discount and on which interest accrues and is paid at maturity
bonus
- the return of principal at the end of all of the interest payments
T-Bonds (Treasury Bonds)
-LONG TERM securities -Issued and mature in more than 10 years
dividend what are they in form of? when are they paid?
-The portion of corporate profits paid out to stockholders as an income return -cash dividends -paid quarterly
bond
-a long-term debt instrument -a formal contract to repay borrowed money with interest at fixed intervals
what is the difference between bond holders and shareholders?
-bond holder- do not get to vote -shareholders- do get to vote
what is the return of zero coupon bonds?
-there is no interest payment. Your return is only a capital gain.
benefit of being a shareholder
-they get a RESIDUAL claim to assets and earnings, and NET INCOME of the firm -residual claim- a claim to a share of earnings after debt obligations have been satisfied. -net income-revenue after expenses
what interest do zero coupon bonds pay? The only return this type of bond pays is capital gain.
0%.
3 things that have to happen to earn YTM
1. all interest payments must be received 2. must reinvest all coupon payments, 3. must hold (not sell) the bond until maturity.
what are the 3 requirements to earn YTM?
1. all interest payments must be received 2. you must reinvest all coupon payments 3. you must hold (not sell) the bond until maturity.
what does a low credit rating indicate?
1. indicates a high risk of default and the firm will pay a high coupon rate.
story of a bond timeline
1. issuance-the issuing firm sells a bond to a bondholder who pays the price of the bond. 2. During the life of the bond, the bondholder will receive coupon rate payments from the issuing firm. 3.maturity- the issuing firm provides the bondholder with the principal of the bond and the contract comes to an end.
what is used to calculate an investor's expected return from a stock?
1. the current dividend I expect to receive from the company 2. the growth in that dividend that I expect for the company 3. the price paid that I pay for the stock.
what should future value always equal?
1000
retained earnings
An amount earned by a corporation and not yet distributed to stockholders.
how do you earn a return if no dividends are paid?
Capital gain- a profit from the sale of property or of an investment.
Retained earnings are _____.
Cumulative earnings of the firm since inception.
1. Of the three possible "$" dollar amount variables which variables should have the same sign?
FV and pmt have the same sign while PV should have the opposite sign.
1. Of the 5 possible variables, ______________________ are set at the time a bond is issued and will not change throughout the life of the bond. As a result, the only variables that can change or react are ________________
FV, pmt, and n; PV and i
fixed & varied variables for bonds
Fixed variables- pmt (fixed coupon), n (fixed maturity), FV (fixed principal) varied variables- PV and I
treasury bonds (or bills)
Government bonds that are issued by the federal government
do debentures have high or low risk? do they have high or low coupon rates?
High risk with a high coupon rate
what equals YTM? what are you solving for when asked to solve for Yield to Maturity?
I - I= YTM (YTM= interest. Put in your 4 variables and then solve for I in your calculator)
what can you solve for when asking about BONDS?
I or PV If you are given I, solve for PV. If you are given PV, solve for I
discount bond
If the market interest rate is higher than my bond's coupon rate, the demand for my bond will be low which will cause its price to decrease.
premium bond
If the market interest rate is lower than my bond's coupon rate, the demand for my bond will be high which will cause its price to increase.
Arrange the following based on a high to low coupon rate: debenture (D), subordinated debenture (S), income bond (I), mortgage bond (M).
M D S I
Relationship between bond prices and market interest rates
Market interest rates have decreased and are now lower than my bond's coupon rate. The demand for my bond will increase since now my bond is relatively more attractive which causes the bond's price to increase **Market interest rates have increased and are now higher than my bond's coupon rate. The demand for my bond will decrease since now my bond is relatively less attractive which causes the bond's price to decrease.
3 credit ratings
Moody's, S&P, and Fitch
If the expected return of a stock is less than my required return, should you buy the stock?
NO DO NOT BUY because it is overvalued
the second way the value of a stock can be calculated what is it based on?
P/E ratio finds the value of a stock based on the annual net income of a company
What are the 2 things a firm can do with net income?
Pay it as dividends or retain it as retained earnings
Payment (PMT)=
Payment (PMT)= Coupon rate x principal (1,000 x .08= $80)
T-bills (treasury bills)
SHORT TERM debt obligations the U.S. government sells to raise money
Market interest rates have increased and are now higher than my bond's coupon rate. what will happen to the demand?
The demand for my bond will decrease since now my bond is relatively less attractive which causes the bond's price to decreases.
Market interest rates have decreased and are now lower than my bond's coupon rate. what will happen to the demand?
The demand for my bond will increase since now my bond is relatively more attractive which causes the bond's price to increase
the relationship between the zero coupon bond and the principal
The price of a zero coupon bond will always be less than the principal.
sign rule for bonds
The signs are always the same for bonds. PV is ALWAYS the opposite sign. FV and pmt is always the same. It doesn't matter what sign, as long as they match.
what happens to the number of shares and the share price, and value of the stock when there are stock repurchases/share buybacks? what does it signal?
This will result in decrease in shares outstanding and not change price. They should be viewed as a great signal since the firm thinks the stock is undervalued. They believe the success of their business will increase so they buy their own shares
scenario 1: discount bond bond is selling at a discount price < principal what is causing it to be unattractive? will you experience a capital gain or loss if you hold the bond to maturity? are you going to end up earning the coupon rate or the YTM?
Unattractive what is causing it to be unattractive? Coupon market < market interest rates will you experience a capital gain or loss if you hold the bond to maturity? A capital gain (market rate) are you going to end up earning the coupon rate or the YTM? The market rate
when do you only split stock?
Whenever you expect prices to go up
If the expected return of a stock is greater than my required return, should you buy the stock? expected return > required return
YES BUY because it is undervalued
YTM what does it include?
Yield To Maturity the total return of a bond includes INCOME RETURN based on the interest payments received and a CAPITAL GAIN return based on the price of a bond.
board of directors
a group of persons elected by the stockholders to manage a corporation
bond who gets it?
a promise to repay a fixed amount of funds -creditors -creditors- a person or company to whom money is owed.
Convertible bonds
allow a bond to be converted into stock at the option of the bondholder.
proxy
allow someone else to vote for you
why are treasury bonds important to the federal government?
allows the government to pay off national debt by selling treasury bonds
High yield bonds
also called return/junk bonds, poor quality bonds that have a high probability of default so in turn will have a high risk and pay a high coupon rate
the interest rate
amount of a bond's payments
what do we treat payments as?
an annuity
DRIPs
an automatic reinvestment that allow a shareholder to have cash dividends reinvested into shares instead of receiving the cash.
The relationship between bond prices and market interest rates is best described as _____________ since bond prices _________ when market interest rates ___________ and bond prices decrease when market interest rates increase
an inverse relationship, increase, decrease
debenture
an unsecured debt, usually with a maturity of 10 years or more backed by general credit rather than by specified assets.
corporate bonds how are they secured?
bonds issued by cooperations or firms By a claim on real estate (assets)
mortgage bonds
bonds secured with real estate as collateral
subordinated Debentures
bonds with a lower claim on the firms assets compared to other debt instruments. They are last in line. High risk and high income rate
Based on a tax argument, investors should have a preference for _____.
capital gains
Credit ratings
classification scheme designed to indicate risk associated with a particular debt instrument.
The promised interest rate on a bond is called the _____ rate.
coupon
income bond when do income bonds only pay interest? why is it good and bad? who is it risky too?
coupon payments paid only if the issuing company has enough earnings to pay for the coupon payment. Income bonds only pay interest if it is earned by the firm. This is risky to the bond issuer. Good for the firm, really bad for the investor example: a football stadium
The investors in a bond are best described as _____.
creditors
what are bondholders?
creditors the issuing firm makes a promise to fulfill the bond contract.
A _____ bond has no collateral securing it.
debentures
The largest risk facing a bond is _____ risk.
default
what is primary the risk of a bond is it unique to the firm?
defaulting (you don't get paid back) which occurs when a firm fails to meet the terms specified in the indenture of a debt issue. This risk is unique to the firm.
treasury bonds are used as a measure of the ____________ since they are considered to be ________________
deficit spending, risk-free.
the coupon rate is _____________ and the rate actually earned by the investor is always the __________ which is determined by the _____________ by the investor.
discounted, YTM, expected return
D0
dividend that was just paid (current/past)
which is more risky, equity or debt?
equity
common stock
equity security
default
failure to meet terms or failure to pay the amount specified in the indenture
_____ bonds have the benefit of lowest risk in the market.
federal
To find the value of any asset what should it include?
find the present value of future cash flows. The cash flows of a stock include dividends
D1
future/expected dividend
what two values should always be the same?
fv and pmt
when do you solve for pv? when do you solve for I?
given I- solve for PV given PV- solve for i
municipal bonds=
government bonds that are issued by a state or municipal government.
Stock repurchases/share buybacks
happen when a firm chooses to repurchase some of its stock.
The relationship between bond prices and market interest rates
have an inverse relationship since bond prices increase when market interest rates decrease and bond prices decrease when market interest rates increase
advantage of DRIPS
have the advantage of convenience and lower brokerage costs and the disadvantage of you still have to pay taxes even if you don't get cash.
stock expected return
how much should you expect to return?
stock value question
how much should you pay for this stock?
bond price question
how much should you pay?
what are the two ways a shareholder can receive a return? which one do they prefer and why?
in the form of a capital gain or a dividends prefer capital gains due to a tax benefit
what happens to the number of shares and the share price, and value of the stock when you split a stock?
increase the number of shares decrease the share price. Overall, your value of stock will still be the same.
two basic groups of bonds based on credit ratings
investment grade and junk
in a premium bond what will happen to the investor? what will the invest earn?
investor will have a capital gain and will ultimately earn the premium .
in a discount bond what will happen to the investor? what will the invest earn?
investor will have a capital loss and will ultimately earn the YTM (market rate).
what happens when the terms of the contract is broken?
it defaults
do convertible bonds have a high or low coupon rate?
low
A firm that pays out high dividends will have a _____ amount of growth and ______ retained earnings and pay out most of its return as _____.
low amount of growth low retained earnings dividends
do mortgage bonds have high or low risk? do they have high or low coupon rates?
low risk and a low coupon rate
Agency problems occur betweeen _____.
managers and owners
A _____ bond has collateral securing it.
mortgage
are mortgage bonds secured or unsecured? why?
mortgage bonds- bonds on real estate secured because they require collateral collateral- something pledged as security for repayment of a loan, to be forfeited in the event of a default.
investment grade
most likely will not default
_____ bonds have the benefit of tax exemption.
municipal
__________ bonds have the benefit of tax exemption.
municipal
**For a bond, ___________ are all set at issuance and __________ change for the life of the bond. The market interest rate ___________ changes.
n, pmt, and FV i & PV always
new retained earnings formula
new retained earnings= old retained earnings + net income - dividend
should you buy a stock if the market value is greater than the stock market price > stock price
no because the stock is overvalued
are convertible bonds the firm's choice?
no, so it benefits the investor
equity holders own ____________ and provides you with ____________
one share of stock; one vote
As an equity holder, owning 1 share of stock provides you with _________vote in order to vote on a________________which is elected by you _______________ and is in control of hiring managers. This is done at the ______________ and if you don't want to attend you could vote by ____________.
one; board of directors; (the shareholders); annual shareholder meeting; proxy
A shareholder would best be called an ____________ and is only entitled to the _____________ of a firm's earnings and assets.
owner, residual liquidation
The stockholders are best described as _____.
owners
what does equity represent in a company? what are equity owners called?
ownership shareholders
2 ways that net income can be used
pay it out as a dividend or retained earnings
bond is selling at a premium
price is greater than the principal.
a bond is selling at a discount
price is less than the principal.
present value
price or what you are willing to pay today as a bond (not the same as principal)
how do you calculate pmt?
principal (1000) x coupon ratee
3 things a bond will specify
principal or par value, the interest rate, and maturity date
agency problems what do managers do that cause these problems?
problems that occur because shareholders are NOT the same as managers because there is a conflict of interest/knowledge between managers and shareholders (owners of the firm). This is because managers make decisions using shareholder's capital (money).
Municipal bonds (munis) do they have a risk of defaulting?
provide investors with the benefit of being tax exempt, YES, they DO have a risk of defaulting.
what does a high credit rating indicate?
rating indicates a low risk of default and the firm will pay a low coupon rate.
trustee
representative of bondholders who enforces the indenture and makes sure the indenture isn't broken
coupon rate
represents the amount of an interest payment a bondholder will receive.
The return earned by a stockholder is best described as a _____ and is considered to be _____ risky than the return earned by a bondholder.
residual; more
what is the coupon rate set as?
set at $1000 and is best described as fixed rate
who does net income and retained earnings belong to?
shareholders
owners are ______________________
shareholders that own stock
Stock valuation is _____________ in nature.
subjective
principal or par value
the amount of the loan
why are stocks hard to value?
the cash flows are residual; there is no promise/pmt. -residual claim- a claim to a share of earnings after debt obligations have been satisfied.
indenture
the contract that specifies the terms of the debt issue.
Retained earnings
the cumulative earnings since the inception (the beginning) of the business. it is NOT CASH.
maturity date
the length of the bonds life, typically more than 10 years
why are treasury bonds important to the federal reserve?
they are used to control the money supply
why are treasury bonds important to investors?
they provide a risk free investment
what happens to retained earnings if a firm chooses to pay high dividends?
they will have LOW retained earnings and most of the return to shareholders will be in the form of DIVIDENDS
where do they get money to pay out bond holders?
through interest expense
what is the reason common stock is issued by firms?
to raise funds
stock splits what do they signal?
trade more shares of stock for a firm's outstanding shares. Stock splits are done in order to signal happy times Makes it easier to trade because regular investors can diversify and afford it
what happens if you are not given a dollar amount?
turn into a decimal and x1000 for PV
if there I a small decimal
turn it back into a percent
are debentures claims secured or unsecured? why?
unsecure because they DO NOT require collateral debenture- an unsecured loan certificate issued by a company, backed by general credit rather than by specified assets.
why are treasury bonds important to us?
us as future taxpayers, the more debt the government has, the more interest we have to pay.
bond yield question
what is YTM?
Scenario 2: premium bond bond is selling at a premium price > principal what is causing the bond to be attractive? will you experience a capital gain or loss if you hold the bond to maturity? Should you care about the coupon rate or the yield to maturity?
what is causing the bond to be attractive? Coupon rate > market interest rates will you experience a capital gain or loss if you hold the bond to maturity? A capital loss. Still earning YTM (market rate) Should you care about the coupon rate or the yield to maturity? YTM because YOU NEVER EARN THE COUPON, ONLY THE MARKET RATE. THIS IS WHY IT IS STUPID -YTM= market rate= required return
what happens to retained earnings if a firm chooses to pay low dividends?
will have high retained earnings and most of the return to shareholders will be in the form of CAPITAL GAIN
junk
you will probably default
